Most of us have had mentors and when it came to becoming a writer three of mine were the late Bill Rivers at Stanford who taught me to think and not just report, legendary book editor Bob Loomis at Random House who felt I might be able to stack enough of those thoughts together to fill a book, and a guy most of you know as Adam Smith, who let me copy his style.

Smith, named after the English economist and writer, helped start both New York and Institutional Investor magazines while at the same time punching out books like The Money Game and Paper Money — huge best sellers that taught regular people how the financial system really worked. That gig explaining the inner workings was what appealed to me. So 30 years ago, having been recently fired for the second time by Steve Jobs, I went to New York and asked permission of Smith to imitate him, though applying his style to technology, not finance. Many such impersonators exist, of course, but I was apparently the first (and last) to ask permission.

And so we became friends, Smith and I, for half of my lifetime and more than a third of his (he, like many of my friends, is now over 80). Smith holds court these days on 5th Avenue at a hedge fund called Craig Drill Capital — a pocket of integrity and thoughtfulness you’d think could not exist in a world so devoted to high frequency trading. When I’m in New York I sometimes visit Smith and he introduces me to his friends, one of those being economist Dr. Al Wojnilower.

Dr. Al started working at the New York Fed two years before I was born and spent 22 years as chief economist at Credit Suisse First Boston. Sixty years on he’s still explaining where the financial world is going and why, somehow doing so without a supercomputer in sight. Dr Al is the best of the best when it comes to understanding those inner workings, in this case of our economy and the world’s. And that’s why he’s the author of the only guest post I’ll ever print in this rag. It’s about the so-called “so-called fiscal cliff” we’re so worried about. His explanation is simple, untainted, and worth reading and he’s allowing me to reprint it here. I’ll come back at the end with a comment.

One more thing: the reason I am writing about this rather than whether the iPad Mini will soon get a retina display is because this is much more important to us as a nation and a world. I’ll get back to technology tomorrow.

FALLING OFF THE FISCAL CLIFF

Dr. Albert M. Wojnilower

December 14, 2012

Although most observers have long understood that fiscal policy is tightening, many may have underestimated the severity of the tightening scheduled for 2013, and the difficulty of reconciling the conflicts of ideology and personal ambition that separate the parties who would have to agree to any mitigating “deal.” While the contestants joust, the economy is already falling off the fiscal cliff.

Most of the public remains blissfully unaware of the scale of the problem. They will be aghast when, soon after year-end, they experience reduced take-home pay and higher tax bills, as well as unforeseen job losses at the many entities, both public and private, that depend, both directly and indirectly, on federal funding and contracts.

Monetary policy has been hard at work to produce sharply lower long-term interest rates, an easing of credit availability, and a recovery in home and stock prices. In recent months (some three years after the end of the Great Recession), households have finally responded by stepping up sharply their purchases of homes, autos, and other durable goods. The increased spending has reduced the rate of personal saving to near its pre-recession lows. Saving will narrow further as unanticipated tax increases bite into incomes until households are forced to curtail their outlays once again, bringing on a new recession.

The improvement in business due to the increased buoyancy of the household sector has been partly offset by reductions in military and state and local government outlays. But more ominous is the fact that business capital investment, which had earlier sustained the economy by rising at double-digit rates, is now actually shrinking — notwithstanding record profit margins and the low credit spreads brought about by Federal Reserve policy. The decline reflects mounting fear that the impending setbacks to household incomes will halt or reverse the upward momentum in consumer spending, which is the chief source of business revenues. The indifference of elected officials to such a disastrous reversal is yet another reason for the widespread loss of confidence in governmental competence.

Growth in credit and debt is a vital attribute of modern economic systems. The funds that I spend to buy your products and services must be re-spent by you on other goods and services. To the extent you put the money in the mattress (that is, fail to recirculate your revenues), the flow of incomes is reduced. Even if you use the funds to buy financial assets rather than goods and services, total incomes will be lowered until the ultimate recipients spend the money. And if the funds are used to pay off debt owed to financial institutions, the income flow is reduced until someone else borrows in order to spend.

The current prospect is that government borrowing will be reduced more rapidly in coming years, as additional revenues are raised from households in ways that compel consumers to curtail their borrowing and spending. This in turn is liable to provoke businesses also to tighten their belts. The result will be that total credit, debt, and incomes grow more slowly, or even shrink. So will GDP. If the shrinkage in incomes and GDP is substantial, the federal budget deficits that we are trying to reduce may actually get larger.

Perhaps, as has happened in recent years, last-minute political agreements will be adopted that, although advertised as cutting spending and raising revenues, actually accomplish the opposite. The damage from Hurricane Sandy may move the fiscal debate in that direction. Natural disasters tend to strengthen business in the short run, because they impel large public and private expenditures for repairing the damage. That sort of budget compromise, if it were of a longer-term nature, would be the best possible outcome of the current fiscal cliff “negotiations.” It would offer hope that, after a modest fiscal shock had been absorbed, GDP growth might reach 2½% later in 2013 (compared to less than 2% this year) and continue to accelerate.

Unfortunately, no such “token” agreement is likely, since President Obama is himself an austerity advocate; he just wants to “distribute” the austerity in different ways than the Republican opposition. An agreement to raise revenues and lower spending along “Simpson-Bowles” lines, the most probable sort of compromise (if there is a compromise), likely would lead to years of GDP growth limited to about 1½% or less, as domestic business investment continues to languish. Business invests when the economy is expected to grow, not when it is condemned to austerity.

Conceivably, no compromise will be reached at all, mainly because of deadlock on the issue of extending the debt ceiling. Unless the ceiling is abolished, or raised in unassailable fashion for a number of years, any agreement will be worthless. The Administration could not accept an agreement that had to be renegotiated every few months to avoid a government shutdown. And without an agreement, the economy would topple over the fiscal cliff into a recession that has no visible means of exit. Business capital spending geared to the future would collapse.

Awareness of these dangers is bound to have a major effect on the Federal Reserve’s policy decisions. Lower interest rates and easier credit have played a key role in strengthening business investment, raising real estate and stock prices, and promoting the recovery in housing starts and consumer buying. As long as stringent fiscal restraint persists, so will monetary ease. Although the current technique of “quantitative ease,” i.e. the large-scale buying of Treasury and mortgage-backed securities in order to lower longer-term rates of interest, may eventually be subject to diminishing returns, it seems to be working well for now. The Federal Reserve has also announced specific thresholds of 6½% for unemployment and 2 1/2% for inflation to underline its commitment to continue aggressive ease until economic growth is satisfactory.

This suggests that, absent a benign fiscal agreement, high quality bond yields may well decline even further. Meanwhile, the cost-of-living index will be sustained by the increasing prices of utilities, transit, education, and medical care, as governmental supports are reduced.

As befits the season, we cross our fingers and depend on “good will towards men” for continued prosperity.

Okay I’m back. As I read it Dr. Al is putting a pox on both their houses. Neither Republicans nor Democrats have viable public positions for growing the economy out of its current mess, and growing out of messes is pretty much the only method we’ve ever had as a nation. So one or both sides don’t actually mean what they say OR they are simply stupid. Could be both. And “good will towards men” means a grudging compromise of sorts where both sides complain about what they’ve had to give up while they achieve what they were actually aiming for all along.